COLUMN-Commodity trading faces altered landscape: John Kemp

By John Kemp
LONDON, Aug 5 (Reuters) – While the U.S. Commodity Futures Trading Commission (CFTC)’s current review of energy markets is likely to result in only modest changes to the formal regulatory framework, centred on tougher position limits and enhanced reporting, the political landscape for commodity trading has changed profoundly.

Traders and investors can expect regulators in both the United States and the United Kingdom to become more aggressive in future — especially if commodity prices show any sign of repeating last year’s surge.

The non-interventionist approach adopted by the CFTC last year is over. In future, regulators are likely to maintain “strategic ambiguity” about whether they will intervene, in order to keep their options open and discourage one-way bets on prices.

In last week’s public hearings, CFTC Chairman Gary Gensler made clear the Commission will not seek to restrict legitimate “speculation” but that it has a mandate to stop “excessive speculation” becoming a burden on interstate commerce and intends to enforce it. The hazy distinction between the two provides plenty of scope for the Commission to take a more activist interest.

THE IRON TRIANGLE
Gensler’s comments mark a significant shift from the Commission’s position last year — when the CFTC defended futures markets and commodity investors from accusations in Congress and the media that speculation was fuelling the surge in oil and other commodity prices.

In testimony to the House Agriculture Committee in May 2008, CFTC Chief Economist Jeffrey Harris argued that “there is little economic evidence to demonstrate that prices are being systematically driven by speculators”.

“Simply put the economic data shows that overall commodity price levels, including agriculture commodity and energy futures prices are being driven by powerful fundamental economic forces and the laws of supply and demand”.

Following pressure from Congress, the CFTC reiterated its defence in reports issued in July and September 2008: “[Our] preliminary assessment is that current oil prices and the increase in oil prices between January 2003 and June 2008 are largely due to fundamental supply and demand factors While [increases in speculative activity] broadly coincided with the run up in crude oil prices, [our] preliminary analysis to date does not support the proposition that speculative activity has systematically driven changes in oil prices”.

CFTC staff and sympathetic academic economists formed a united front with participants within the futures industry and exchanges to reject accusations that speculation had played any part in the run up in prices. In fact they cite each other to support the same argument.

In last week’s public hearings, ICE Chairman Jeffrey Sprecher emphasised that “no quantitative study has shown that speculation in futures markets was the cause of increased energy commodity prices last year”. CME Chief Executive Chief Executive Craig Donohue claimed since the publication of the CFTC reports the previous year “not a single reliable study has contradicted [their] findings”.

WILTING UNDER FIRE
So long as the industry, regulators and academics working on commodity trading issues were united, and Congress and the media lacked evidence to challenge this line, it could be sustained against “populist” demands for intervention. But several developments over the last nine months have made it impossible to sustain:

(a) In a strongly worded dissent from the CFTC’s September report, Commissioner Bart Chilton argued that absence of evidence about a speculative impact was not the same as evidence of absence. He drew attention to the limitations of the data on which much of the analysis was based, and has pressed for the report’s conclusions to be revised when an update is issued this month.

(b) The CFTC’s reclassification of a huge trading position in the oil market last summer, together with evidence gathered by congressional investigators and presented in the current public hearings, has shown positions in futures markets are much larger than was widely known. Markets are much more concentrated in the hands of a small number of dominant players.

(c) Much of the academic defence of the way prices are set was based on fancy econometrics and some version of the efficient markets hypothesis (EMH), both of which have been discredited by the financial crisis.

(d) The analysis in the CFTC reports and academic studies is based on the flawed distinction between commercial and non-commercial traders contained in the CFTC’s weekly reports. It fails to take account of the much larger positions being held in the OTC markets. The data is simply not robust or comprehensive enough to support the strong conclusions the CFTC and many academic authors have drawn from it.

(e) Evidence of settlement failures in some of the smaller, less liquid agricultural futures contracts, with prices failing to converge with the physical spot market on expiry, has caused a break between the futures industry and the powerful farming lobby. As the CFTC reports to the agriculture committees in the House and Senate so speculators have made powerful enemies.

(f) There is growing public scepticism about how the financial services industry, which had to be rescued from oblivion with trillions of dollars of taxpayers’ money as recently as six months ago, can now be reporting massive profits and paying large bonuses.

DAYLIGHT ON THE MAGIC
As I have argued elsewhere, the most likely result of the CFTC’s review is a fairly modest tightening of position limits coupled with a tougher approach to granting exemptions and more comprehensive position reporting. There is no political momentum to impose severe restrictions on the size of positions that pension funds and other large financial investors can run in commodity markets.

But that does not mean nothing will change. Many trading practices that thrived in quiet obscurity simply cannot survive now that Congress has exposed them to daylight. The iron triangle of industry, academics and regulators that prevented stricter regulation of commodity markets has been thrown onto the defensive.

In particular, the CFTC may be forced to soften the strong “no evidence” conclusion to admit the evidence is inconclusive. The language is crucial. If the conclusion is softened, it would give the CFTC more scope to intervene in future.

In the past, industry participants could rely on the Commission to block efforts to intervene. But if prices spike again, the CFTC’s no-intervention stance may be replaced by a more ambiguous one in which the regulator warns it is watching closely and has the right and the willingness to intervene if it believes speculation is “excessive”.

In the same way that “strategic ambiguity” is a key part of the foreign policy arsenal for dealing with sensitive topics such as Iran and Taiwan, it may become a key part of the commodities landscape in future.

The CFTC will almost certainly ask more questions about very large positions and could order holders to them to reduce them. In a more aggressive move, the CFTC could threaten to impose a “liquidation-only” rule (forbidding participants from increasing their existing positions). It would increase uncertainty and act as a deterrent to the holders of large long positions relying on their buying power in thinly traded markets to support prices. That would thus break the one-way momentum behind a price spike.